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Isolation and Aggregation in Economics Ekkehart Schlicht Isolation and Aggregation in Economics Springer-Verlag Berlin Heidelberg NewYork Tokyo Prof. Dr. Ekkehart Schlicht Institut flir Volkswirtschaftslehre, Technische Hochschule Darmstadt, SchloD D-6100 Darmstadt (c) Ekkehart Schlicht. All rights reserved. This work may be freely distributed for non-commercial use. The original hard cover copy is available for €/$ 50.- here, ISBN 3-540- 15254-7 Springer-Verlag Berlin Heidelberg New York Tokyo ISBN 0-387- 15254-7 Springer-Verhg New York Heidelberg Berlin Tokyo LI- of Cwgress Catnloging-in-Pubkation DPta Schlicht, Ekkehart, Isolation and aggregation in economics. Bibliography: p. Includes indexes. I. Macroeconomics. I. litle. HB172.5.S35 1985 339 85-12638 ISBN 0-387-15254-7 (US.) 'This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically those of translation, reprinting, re-use of illustrations, broad- casting, reproduction by photocopying machine or similar means, and storage in data banks. Under 5 54 of the German Copyright Law where copies are made for other than private use a fee is payable to "VerwertungsgeseUschatl Wort", Munich. 0 Springer-Verlag Berlin Heidelberg 1985 Printed in Germany The use of general descriptive names, trade marks, etc. in this publication, even if the former are not especially identified, is not to be taken as a sign that such names, as understood by the Trade Marks and Merchandise Marks Act. may accordingly by used hdyby anyone. Typesetting, Printing and Bookbinding: Konrad Triltrch, Graphischer Betrieb, Wonburg 2142/3140-543210 For my family Preface In order to solve a given problem, economic analysis is com- pelled to concentrate on the interaction of selected factors while disregarding a multitude of other influences. This book offers a discussion of certain central premises involved here and draws some analytical consequences. The argument is fo- cused on process analysis, i.e., on the analysis of economic processes within a given institutional setting, although certain corollaries for institutional analysis are patent. Many colleagues and students have helped me, for many years, to develop the views presented here, and it seems im- possible to trace individual influences. Thus I can only ex- press my indebtedness in a macro sense. I wish to thank the Westdeutscher Verlag for its kind per- mission to use material from my Grundlagen der okonomi- schen Analyse. The results of Chap. 4 were presented at the Econometric Society European Meeting in Pisa, 1983. Dr. W. A. Miiller from Springer-Verlag has encouraged me to write this book and has been helpful in many ways. Darmstadt, March 1985 Ekkehart Schlicht Table of Contents 1 . The Setting of the Argument 1.1 Two Characteristics of Economic Analysis ... 1.2 The Provisional Nature of Economic Data ... 1.2.1 Data and Variables ......... 1.2.2 Provisional Data .......... 1.2.3 The Ceteris Paribus Clause ...... 1.2.4 A Difficulty in Applications ...... 1.2.5 Economics as a Deductive Science ... 1.2.6 The Homo Oeconomicus ....... 1.2.7 The Isolation Principle ........ 1.2.8 The Moving Equilibrium Method ... 1.2.9 ?he Nature of Economic Theories ... 1.2.10 Consequences for Econometrics .... 1.3 Intricacies in Macroeconomic Analysis .... 1.3.1 Economic Aggregates and Macro- economic Problems ......... 1.3.2 The Microeconomic Approach to Macroeconomic Problems ...... 1.3.3 The Macroeconomic Approach to Macroeconomic Problems ...... 1.3.4 The Hermeneutic Aggregation Problem . 1.3.5 The Typical Agent .......... 1.3.6 The Representative Agent ...... 1.3.7 Micro and Macro Behaviour Might Differ 1.3.8 Macroeconomics and Aggregation ... 1.4 Isolation and Aggregation ......... 2. On Isolation ...... .......... 2.1 The Heuristic View . ........... 2.2 The Isolating Approach .......... 2.2.1 The Marshallian Method ....... 17 2.2.2 Substantive and Hypothetical Isolation . 18 2.3 Substantive Isolation ............ 19 2.3.1 The Isolation Principle ...19 2.3.2 Temporal Isolation : ......... 19 2.3.3 Causal Isolation ........... 20 2.4 Hypothetical Isolation .....21 2.4.1 Analytical Isolation ......21 2.4.2 Hypothetical Theories ....22 2.4.3 A Remark on Scientific Discourse .... 22 2.5 Economic Thinking ............ 24 3. The Moving Equilibrium Method ........ 27 3.1 ~conomicEquilibrium ....27 3.2 Moving Equilibria ............. 29 3.2.1 Partial Analysis .....29 3.2.2 Comparative Statics ......... 30 3.2.3 'The Moving Equilibrium Method .... 32 3.3 Extensions ................ 32 3.3.1 The Marshallian Market ........ 32 3.3.2 A Qualification ........... 36 3.3.3 A Ramification , ........... 37 3.3.4 Discontinuities ............ 38 3.4 Mathematical Aspects ........... 39 3.4.1 Approximation by Moving Equilibrium . 39 3.4.2 Additional Observations ..42 3.5 Hicks-d'Alembert's Principle ...45 4 . Econometric Implications ......47 Linlung Theory and Empirical Evidence ... 47 Invariances in Coefficients Versus Invariances in Their Stability ............. 47 4.2.1 The Classical Invariance Premise .... 47 4.2.2 Economic Models as "Models of Thought" 49 4.2.3 Short-Run Invariances ...50 4.2.4 Invariances in Stabilities . 51 Estimation in a Linear Model with Random Walk Coefficients ............. 52 4.3.1 The Model ....... 4.3.2 Notation ........ 4.3.3 A Parametrization .... 4.3.4 Estimating the Coefficients 4.3.5 Estimation of Variances . 4.3.6 An Approximation .... 4.4 Unsettled Problems ...... 5 . The Nature of Macroeconomic Laws 5.1 On Reductionism ............. 5.2 The Macroeconomic Method ........ 5.2.1 Macroeconomics as an Isolating Approach 5.2.2 The Aggregation Principle ....... 5.2.3 ~~~re~ationand Moving Equilibrium . 5.2.4 The Macroeconomic Isolation Principle . 5.3 Closed Aggregation and the Context Dependency of Economic Laws ....... 5.3.1 Closed VerSus Open Aggregation: A Comparison in Statics ........ 5.3.2 The Context Dependency of Economic Relations ......... 5.4 Qualitative Differences Between Microeconomic and Macroeconomic Laws ......... 5.4.1 Three Differences .......... 5.4.2 The Smoothing Effect ......... 5.4.3 The Elimination Effect ........ 5.4.4 The System Effect .......... 5.5 Hermeneutic Aggregation ......... 5.5.1 The Status of the Aggregation Problem . 5.5.2 Revised Reductionism ........ 5.5.3 Macroeconomic Order and Micro- economic Chaos ........... 5.5.4 Structural Causality ......... 5.6 Adequate Aggregation ........... 6. Epilogue: Economic Imagination . References .......... ........ Author Index ......... Subject Index ......... 1. The Setting of the Argument The laws of economics are to be wmpared to the law of the tides, rather than with the simple and exact law of gravitation. Alfred Marshall 1.1 Two Characteristics of Economic Analysis Economic phenomena are the outcomes of a plethora of factors, and economic analysis, unable to tackle them all, is compelled to select those factors which seem to be the most important, and to consider all other influences as data of the analysis. But these data are only provisional since they are wandering themselves. One characteristic of economic analysis is, then, that it is built on a moving foundation. Furthermore, economics is not concerned with the idiosyncrasies of particular cases, but looks for general rules linking typical incidents. Usually these rules cannot be distilled stringently from the multitude of individual actions, and economics is bound, hence, to start from as- sumptions on the behaviour of aggregates - or "representative" agents - which are linked to individual actions just vaguely. This way of proceeding is most apparent, and most important, in the case of macroeconon&, where we assume aggregate behaviour from the outset, but it is also of ;elevance for microeconomics. The following discussion sets out to probe into these problems: the provisional nature of economic data and the nature of aggregative assumptions. Since we are going to tackle these problems by isolation and aggregation, these considerations set the themes for the book. 1.2 The Provisional Nature of Economic Data 1.2.1 Data and Variables We explain economic phenomena by relating them to their causes. Price formation in a particular market is, for instance, explained by the inter- action of supply and demand. The conditions of supply and demand are the data of this problem which are presupposed in the explanation of the variable, which is the price in our example. 'Quite generally those conditions which are presupposed in the analysis are the data, and those phenomena we seek to explain are the variables of the problem '. 2.2 Provisional Data An economic datum is not, however, absolutely fixed like a natural constant. Rather it is to be viewed as being determined by other causes: The supply behaviour of firms is influenced by their strategies and the technologcal conditions under which they operate, and the demand of households is influenced by their incomes and preferences. Again, these are not ultimate data since preferences, strategies and technologies are subject to various influences and might change over time. Hence economic data are typically only of a provisional nature. This holds true quite generally since economic processes are built on psychologml factors and are embedded in and interact with sociological processes. Hence psychological and sociological circumstances are to be considered as data, and we know that these change over time: They have a dynamic of their own and are themselves influenced by the economic processes. But even if we aim to incorporate all relevant
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